Beware the Fed’s Balance Sheet Unwinding

• There was a strong relation between the Fed’s balance sheet and stock markets, with the Fed tending to respond to stock market declines or the deteriorating economic outlook reflected in negative market returns.

• The Fed responded more strongly to negative stock market returns (expanding its balance sheet) than to positive market returns (contracting its balance sheet).

• The market was more sensitive to the Fed’s balance sheet contractions than to balance sheet expansions, implying a significant fall in stock markets was likely if the Fed surprised the market with a larger-than-expected contraction or unwinding of its unconventional monetary policy – the stock market mainly responded to the unexpected component of the Fed’s actions.

• The timing of the market reactions suggests that the stock market largely responded to realized balance sheet changes as opposed to announcement effects that would imply an earlier reaction.

• Stock markets responded to the Fed’s balance sheet expansion with positive returns in the one to four weeks following the Fed’s actions. A 10% expansion of the Fed’s balance sheet was estimated to result in a positive 9.1% impact on cumulative stock market returns over the following five to 10 weeks, with most of the effect occurring in the five weeks following the Fed’s intervention.

• The excess liquidity generated by the Fed’s transactions in fixed income securities led to subsequent buying pressure in riskier asset classes, including equities. It is also possible that stock market participants reacted, although in a slightly delayed manner, to the reduction in fixed income yields that was a direct consequence of the Fed’s asset purchases, and subsequently revalued equities at lower opportunity costs of capital.

• While the Fed’s balance sheet expansions were more rapid than its contractions, the stock market was more sensitive to contractions. In the full sample, the estimated stock return impact of a 10% contraction in the Fed’s balance sheet was a return of -9.1%; in the Q1 2018-Q3 2019 contraction subperiod and the contraction years 2015-2019, the estimated impacts were -11.3% and -16.7%, respectively.

• Sectors that tend to be more cyclical, such as consumer durables, were far more sensitive to the Fed’s interventions than less cyclical sectors, such as utilities, and small stocks were substantially more sensitive to the Fed’s actions than large stocks. These findings support the theory that the Fed’s asset purchases impact stock returns by changing expectations of future economic conditions.

• One-third to one-half of the S&P 500’s 31% rebound from March to May 2020 can be attributed to the Fed’s aggressive balance sheet expansion during March and April of that year. In terms of returns, the Fed’s balance sheet expansion from around $4 trillion to $7 trillion was estimated to account for a stock market return of 12%-15% in the eight weeks to May 2020, with a further 5% as the full cumulative effect.

Putniņš’ findings led him to conclude that Fed policies have implications in terms of the impact of central banks unwinding the large balance sheet holdings accumulated during the pandemic. He added: “Tapering that is in line with expectations may have minimal impact on the stock market, but tapering or contraction that is faster or larger than expected is likely to trigger a stock market reaction. The large size of the Fed’s accumulated position and the high market sensitivity to Fed balance sheet contractions implies that the Fed’s actions are likely to be a major driver of stock returns and volatility in the near term.”

Putniņš also concluded: “The countercyclical use of QE and it substantial impacts implies increased divergence between stock markets and the economy particularly during crises. In the absence of central bank interventions, stock markets are leading indicators of economic growth – when future growth is expected to be high, leading to high expected corporate cash flows, company valuations tend to be high. However, when central banks intervene, this positive correlation between the stock market and the future health of the economy breaks down and could even become negative because of the countercyclicality of the central bank’s actions – expansionary monetary stimulus putting upward pressure on stock prices during periods of deteriorating economic outlook. The increased magnitude of central bank intervention amplifies these effects leading to a greater divergence between stock markets and the real economy. … The results suggest that a central bank need not directly buy equities to have a substantial effect on equity markets.”

The impact of rising rates creates a conundrum for the Federal Reserve, as its policy tool is to raise real interest rates sufficiently to slow economic growth and dampen inflation – as Paul Volcker did in 1979. Unfortunately, while raising real rates would slow economic growth and dampen inflation, it would also worsen the problem of our debt-to-GDP ratio, now exceeding 100%. This has led to concerns about rising inflation (fueled by very stimulative monetary and fiscal policies) and the negative effects on future economic growth.

Why would a large federal debt have negative effects on the economy?

Economists have noted several reasons why high levels of debt-to-GDP can adversely impact medium- and long-term economic growth:

• High public debt can negatively affect capital stock accumulation and economic growth via heightened long-term interest rates, higher distortionary tax rates and inflation, and by placing future restraints on countercyclical fiscal policies that will be needed to fight the next recession (which may lead to increased volatility and lower growth rates).

• Large increases in the debt-to-GDP ratio could lead to not only much higher taxes, and thus lower future incomes, but also intergenerational inequity.

• Increased government borrowing competes for funds in capital markets, crowding out private investment by raising interest rates. Higher rates, along with higher taxes, increase the cost of capital and thus stifle innovation and productivity, reducing economic growth.

• If the government’s debt trajectory spirals upward persistently, investors may start to question the government’s ability to repay debt and may therefore demand even higher interest rates.

• Growing interest payments consume an increasing portion of the federal budget, leaving lesser amounts of public investment for research and development, infrastructure and education.

With that understanding, we turn to a brief review of the literature on the concerns about the potential for negatively impacting economic growth once debt-to-GDP approaches the level we are now at in the U.S.

The evidence

Empirical research, including the 2011 study, “The Real Effects of Debt,” the 2012 study, “Is High Public Debt Always Harmful to Economic Growth?,” the 2013 study, “Does High Public Debt Consistently Stifle Economic Growth?,” the 2020 paper, “Debt and Growth: A Decade of Studies,” and the 2021 studies, “The Impact of Public Debt on Economic Growth” and “Public Debt and Economic Growth: Panel Data Evidence for Asian Countries,” have found that at moderate levels, debt improved welfare and enhanced growth. However, high levels can be damaging. Beyond a certain level, debt was a drag on growth. There is a negative relationship between high levels of government debt and economic growth with a threshold between 75% and 100% of GDP, and the negative impact gets more pronounced as debt increases. One only has to look to Japan, with a debt-to-GDP ratio well in excess of 250% (and headed higher) and stuck in a 30-year period of weak economic growth, to raise concerns about our experiment in massive deficit spending at a time when our debt-to-GDP ratio is already in excess of 100% (other problems, such as an aging population, have contributed to Japan’s economic weakness).

Investor takeaways

The empirical research demonstrates that there has been a strong relationship between the Fed’s balance sheet and stock markets as the Fed responded to falling stock prices by engaging in asset purchases, which in turn tended to push stock prices back up. The reverse effects were also present, although the Fed responded more strongly to negative stock market returns than it did to positive market returns, and the stock market was more sensitive to the Fed’s balance sheet contractions than it was to balance sheet expansions.

Looking forward, investors should consider the potential impact on equity and bond markets as central banks begin to unwind the massive growth in their balance sheets – the Fed’s balance sheet has grown to about $9 trillion. Never before has the Fed had to engage in such large withdrawals of liquidity. Thus, no one knows the impact that will have on both interest rates and equity prices. However, the empirical evidence does suggest there are significant risks to equity prices, especially for longer duration assets (including growth stocks, whose valuations were driven to historically high levels by the Fed’s easy monetary policy). The evidence suggests that those risks will increase greatly if the Fed surprises markets by reducing its balance sheet at a faster pace than it has announced because inflation continues to be persistent at high levels.

As always, equity allocations should not exceed an investor’s ability, willingness or need to take risk. This is particularly important because of the risks that Fed policies could lead to both stocks and bonds doing poorly at the same time. Those risks are why investors may consider including allocations to investments that have low to no correlation to both stocks and bonds. Examples of those allocations are:

• Reinsurance (which has no correlation to the economic cycle risk of stocks or the inflation risk of bonds), accessed via such funds as Stone Ridge’s SRRIX and SHRIX, and Amundi Pioneer’s XILSX;

• Long-short factor funds, such as AQR’s QSPRX and QRPRX; and

• Private credit funds, such as Cliffwater’s CCLFX (which makes senior secured loans to middle market companies with an average loan-to-value ratio of only about 50%) and CELFX (in addition to middle market lending, it also invests in assets that have little to no exposure to economic cycle risk such as drug royalties, litigation finance, and life and structured settlements), which invest in floating rate loans (eliminating duration/inflation risk); and Stone Ridge’s LENDX, which invests in fixed rate but shorter term (expected duration of about one year), fully amortizing prime (not junk) consumer, small business and student loans (minimizing inflation risk while accepting economic cycle risks, though those risks have been well below that of stocks).

Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.

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